Friday rally does little to stem the fall
Despite a strong rally on Friday, stocks continued their slide, with more of the major averages entering bear market territory last week. The Dow Jones Industrial Average fell 1.42% to end the week at 15,973, while the S&P 500 Index dropped 0.86% to 1,864 and the Nasdaq Composite Index was down 0.59% to 4,337. Bonds continued to benefit from the investor flight to quality, with the yield on the benchmark 10-year U.S. Treasury falling from 1.83% to 1.75% as its price rose.
In a world in which central bank stimulus is losing its sway over markets, investors are reliant on earnings growth for equity market returns — something that will be hard to produce in an environment of decelerating growth. This all suggests that markets will remain volatile and may see lower valuations before we can assume we have found a long-term bottom. One solution to navigating the turmoil until then: Continue to emphasize large-cap, quality companies.
A world of woe
More and more equity markets globally have slipped into bear market territory, typically defined as losses of 20% or more from the prior peak. By that definition, the global stock market, as measured by the MSCI All-Country World Index, has now entered a bear market. Many of last year’s momentum plays are among the worst performers. For example, at the lows last week, the Nasdaq Biotech Index was down nearly 30% year-to-date. As has been the case since the start of the year, the weakness is not confined to equities. Credit has also suffered, with high yield spreads — the difference between the yields of high yield bonds and those of comparable-maturity Treasuries — trading at levels last seen in the summer of 2009.
European shares are now down more than 15% year-to-date, with the worst damage in southern European and bank shares. Even Japan, a relatively cheap market with a sound banking system, is getting hit. The Japanese market continues to slide on the back of falling bank shares and a rising yen. Part of the problem is that negative rates imposed by the central bank are being seen as a tax on the banking system and are not providing the expected boost.
In addition to broader concerns over global growth, plunging oil prices and tightening financial conditions, equity investors are contending with a steady erosion in earnings and future estimates. With more than half of the companies in the S&P 500 having issued their fourth-quarter results, both earnings per share and sales growth are down 5% year-over-year. With earnings heading lower and investors taking less solace from central bank stimulus — the market took little comfort in Janet Yellen’s Congressional testimony last week — stocks are struggling to find a bottom. Unfortunately, while valuations have become more reasonable, outside of emerging markets, they are not particularly cheap.
While selling stocks and credit, investors continue to rotate into safe havens, notably sovereign debt and gold. On the latter, prices climbed above $1,200 an ounce for the first time in a year. Investors may also take some solace in the idea that government bonds are fulfilling their traditional role as a safe haven. The drop in long-term yields has pushed the U.S. Treasury curve to its flattest since 2007, with the difference between 2- and 10-year yields less than 1%. Unlike earlier in the year when the drop in yields was being driven mostly by falling inflation expectations, real (i.e., after-inflation) yields are also beginning to fall as investors become increasingly concerned over economic growth.
However, it is worth highlighting that despite the increasingly pessimistic tone, the U.S. economy is not falling off a cliff. Last week’s retail sales report continues to support our thesis that while the manufacturing sector is in a contraction, the household and services sectors appear to be growing.